CIO sees select opportunities in secular growth trends,including artificial intelligence, reshoring, infrastructure, energy transition, and healthcare innovation. (UBS)

The rally has been supported by a reprieve in bond yields, the return of earnings growth, a more balanced Federal Reserve tone, and cooler-than-expected inflation data. We believe conditions in aggregate will remain favorable for equities, though we acknowledge the potential risks—including headwinds from the resumption of student debt repayments, discord in Washington over the government budget, and heightened geopolitical risks. There might be some bumps along the way, but we expect the S&P 500 to grind higher towards 4,700 by year-end 2024, driven by a recovery in earnings growth.

The third quarter earnings season has confirmed that the three-quarter earnings recession is over. Corporate profits growth is pacing at 5% y/y—beating analysts’ initial estimates for no growth. We expect the earnings recovery momentum to accelerate in 2024 and are looking for high-single-digit earnings growth. The labor market remains healthy, with strong job creation, relatively low initial jobless claims, and ample job openings. This should continue to support consumer spending.

Falling bond yields should help ease the recent pressure on equity valuations. In less than a month, the yield on the 10-year Treasury has pulled back 50bps after relentlessly rising for several months and piercing 5%—the highest level since 2007. We expect it to fall further towards 4% by year end, as economic growth cools and it becomes clearer that the Fed has already ended its hiking cycle. Inflation data is starting to suggest that monetary policy is sufficiently restrictive, with October CPI surprising to the downside.

While we remain positive on equities, we believe a balanced approach is appropriate. We favor quality stocks—within our tactical equity themes "Pricing power standouts” and "Time for quality" fit that bill. We would continue to take advantage of recent laggards ("Investing in self-help”), as well as segments of the market where weak demand has troughed and earnings are set to inflect higher—our newly launched "Select semis” theme embodies this.

We also see select opportunities in secular growth trends, including artificial intelligence, reshoring, infrastructure, energy transition, and healthcare innovation—which can be accessed through our “Made in America” and “Diabetes and obesity” themes.

1. Select semis—We believe a bruising downturn in the key end markets (PCs, servers, and smartphones) is near an end, setting up a better backdrop for select semiconductor suppliers. We focus on companies that we believe will benefit from the recovery in key end markets and where consensus earnings estimates, which have moved off the lows, still do not capture the potential upside of improved end markets and restocking.

2. Diabetes and obesity—Diabetes and obesity are prevalent diseases with high unmet needs, but recent treatment innovations appear promising. We believe the pullback in diabetes-related stocks offers a tactical entry point to what we see as an attractive secular growth story. We focus on the market leaders across treatment categories, where we believe there is upside to profit estimates driven by new product cycles and increased penetration in growing addressable markets.

3. Investing in self-help—In a slowing economic growth environment, we believe companies with self-help measures to enhance profitability are likely to be better positioned and rewarded by investors. We identify companies that have clear and measurable initiatives—with emphasis on restructuring and product portfolio and capital use optimization—and are likely to increase margins and cash flows regardless of an uncertain macro backdrop.

4. Made in America—Over the last two years, the US Congress has passed three acts aiming to upgrade US infrastructure and boost domestic manufacturing of critical resources. Together, these pieces of legislation set the nation up to embark on one of the most significant government investment spending plans we have seen in years.

5. Pricing power standouts—Still-elevated input costs have created a more challenging backdrop for many businesses. Companies with pricing power should be better able to pass on these costs to consumers and protect profit margins. We identify companies with pricing power as those with historically high and stable gross profit margins and a large market share in their respective industries.

6. Time for quality—High-quality stocks tend to perform well later in the business cycle or when the economy is in recession. With limited or no slack in the economy, it is clear that the business cycle is somewhat mature. This suggests that investors should focus on high-quality companies, which we define as those with a high return on invested capital (ROIC) and stable profit margins.

Reach out to your UBS financial advisor for a copy of the full report “Tactical US Equity Themes: Monthly update“ 15 November 2023.

Click here to read CIO's equity outlook into 2024.